Why Do Forex/S&P 500 Correlations Say the Japanese Yen Might Surge?

Summary: Why are correlations between the Dollar (ticker: USDOLLAR), S&P 500 (ticker: SPY), and Treasury Yields (ticker: SHY) broken? And most importantly—why might this signal that the USD could tumble versus the Yen?

Market conditions are extremely unusual as the S&P 500 fell sharply, the Australian Dollar rallied, and US Treasury Yields rose all at the same time. Long-term correlations show that’s unusual to say the least—the S&P 500 has been very correlated to the AUDUSD, while long-term studies emphasize that Treasury yields typically move inversely to stock markets. What gives?

Yesterday we highlighted reasons for which it might be a huge week for forex markets. Short version: FX volatility prices are on the verge of a major surge higher, while strange conditions in other markets warn that conditions are anything but normal.

We might be on the verge of a potentially substantial stock market sell-off and broader market deleveraging on the scale we haven’t seen since the Flash Crash of 2010 and Financial Crisis of 07/08.

If our hypothesis is correct and there is a dramatic deleveraging across financial markets, it makes sense to look atcurrencies/stocks/bonds in which positioning is at its most one-sided.

In FX that’s the Japanese Yen (ticker: FXY).

The chart below emphasizes that Japanese Yen positioning remains extremely short (USDJPY-long). As arguably the most popular FX trade in recent years, traders have rushed to sell the JPY as it trades to multi-year lows (USDJPY highs).

The fact that the US Dollar fell more broadly emphasized the importance of the short-JPY trade: there are so many speculators long USDJPY that a major breakdown could force broader Dollar weakness. It can’t be a coincidence that the EURUSD simultaneously cleared $1.31 and the AUDUSD strengthened despite simultaneous S&P 500 declines.

It’s difficult to time trades based on Commitment of Traders data as it’s only updated once per week and even then on a delay. Thus we look to our realtime FXCM Speculative Sentiment Index data for more up-to-date analysis:

Retail speculators have grown extremely net-long the US Dollar against the Japanese Yen as it falls sharply off of recent peaks.

We most often use our proprietary Speculative Sentiment Index data as a contrarian indicator to price action. In plain English: if everyone’s buying we want to sell and vice versa. It’s no surprise to note that our sentiment-based trading strategies are short USDJPY and more broadly short the US Dollar. Here’s a summary on major pairs:

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